Development of the Freehold Lease

The Pennsylvania farm which had been virtually worthless prior to the discovery of rock oil in 1859, and which sold for $2 million dollars in 1865 (see “About 'Owning' Petroleum & Natural Gas ”), was auctioned for $4.37 in 1878, after the flow of oil had mysteriously stopped1. The energy company that literally and figuratively ‘bought the farm’ could not have been pleased.

The Pennsylvania example illustrates one side of the difficulty associated with fairly structuring a property transaction when neither party to the transaction knows the value of the property. Finding oil and gas requires land on which to explore, technical expertise, a lot of money, and good luck. The typical energy company has expertise and access to capital, but cannot afford to maintain a land inventory for exploration if the land is bought outright at a price determined by what ‘might’ be under it. The other side of the coin is that owners of subsurface oil and gas are naturally reluctant to sell outright for substantially less than the value of the hydrocarbons which might be under their land.

Out of this conundrum has evolved the oil and gas lease agreement under which almost all oil and gas industry operations involving drilling and production are conducted.

A lease agreement typically provides for an energy company (the lessee) to pay an owner (the lessor) a sum of money (the bonus consideration) for the exclusive right, but not the obligation, to conduct exploration and/or development on the owner-lessor’s lands for an agreed period of time (the primary term) and to produce any leased substances which may be found to exist beneath the lands until these substances are depleted. The energy company’s right to produce is invariably coupled with an obligation to pay the owner an agreed share of any leased substances produced and marketed from the lands (the royalty). The owner-lessor also usually receives rent on an annual basis during the primary term before production is established (the delay rental).

At all times, the form of lease agreement under which energy companies acquire rights to government-owned subsurface oil and gas in Canada ( “Crown lands”) has been prescribed by the appropriate federal or provincial agency, as owner of the resource. For instance in Alberta, since 1930, the Alberta Energy Department or its predecessors ( “Alberta Energy”) has determined the form of lease agreement under which energy companies may lease Crown lands, including the length of the primary term and the royalty rate. The only ‘negotiable’ term in an Alberta Crown lease is the bonus consideration. Oil companies seeking to lease available Crown lands in Alberta bid for these rights by sealed tender at regularly scheduled ‘Crown sales’ with lease rights going to the oil company submitting the highest bonus consideration. In response to changing economic circumstances, Alberta Energy has modified the prescribed form of Crown lease agreement on a number of occasions in an effort to extract maximum value from the Province's resource asset, or, in recent times, to encourage the energy industry to invest in Alberta rather than elsewhere.

In the other prairie provinces, Crown lease forms are prescribed and modified in a similar manner –for the benefit of the citizens of the province who collectively own the resource (see "Crown Leases").

Similarly, where petroleum and natural gas is owned by the Canadian Pacific Railway Company (the “CPR”), the Hudson’s Bay Company (the “HBC”), or their successor corporations (see “About Freehold Mineral Rights”), the form of lease agreement under which energy companies may acquire rights to explore for and produce the hydrocarbons owned by these corporations has, at all times, been dictated by the owner of the resource, and changes to these lease forms have been for the benefit of the resource owner (see "Other Industry Lease Forms").

Only in the case of petroleum and natural gas owned by individual freeholders is the form of lease agreement dictated and modified by someone other than the owner of the resource. Freehold lease agreements are prescribed by the energy company seeking to lease the freehold owner’s hydrocarbons.

More than seventy years ago, the late Professor Maurice Merrill, a renowned authority on United States oil and gas law, described freehold leasing as follows:

“The parties do not, by mutual negotiation, arrive at an agreement as to terms, the result of which is embodied in a written instrument whose language is as much that of one party as of the other. The lessee comes armed with a printed form, the product of legal and business experience. It is idle to suggest that the lessor can afford himself any adequate protection through haggling over terms” 2

For Canadian freehold owners the situation is much worse. The corporate-friendly Canadian judiciary either doesn’t agree with the late professor or doesn’t care. For the most part, Canadian courts interpret freehold leases as if the parties to the lease had, by mutual negotiation, arrived at an agreement as to terms, the result of which was embodied in a written instrument whose language was as much that of one party as the other.

For most of the 20th century, hydrocarbon exploration in western Canada was focussed on oil. Although several significant oil discoveries were made in western Canada in the early 1900's (Norman Wells in 1919 and Turner Valley in 1936), attempts to extend these discoveries into other areas of western Canada proved to be unsuccessful.

Oil exploration in the United States during the same time period was much more successful. In 1901, a well drilled on a salt dome structure at Spindletop, along the TexasGulf coast, blew in at 100,000 barrels of oil per day. Lands within the Spindletop field (or Swindletop as it came to be known by freeholders) changed hands for up to $900,000 per acre. Subsequent drilling on other salt dome structures in Texas and Louisiana resulted in further significant discoveries. In 1905, an even larger discovery was made near Tulsa, Oklahoma, on a different type of geological feature. By the late 1940's, most of the conventional oil reserves in the lower 48 states had been discovered and the current framework of the U.S. domestic oil and gas industry had largely been established - a number of major corporations controlled the production in the principal producing states of California, Louisiana, Oklahoma and Texas.

The oil and gas potential of the western Canadian sedimentary basin only became apparent in 1947, when Imperial Oil Limited discovered a giant field in a subsurface reef of Devonian age at Leduc, Alberta. The magnitude of the Leduc discovery and the fact that the location of ancient subsurface reefs similar to Leduc could be ascertained using seismic technology attracted the attention of major oil companies with established United States production. Over the following decade, the majority of exploration in western Canada was conducted by these ‘majors’, or their Canadian subsidiaries.

Freehold ownership of subsurface oil and gas is the rule rather than the exception in the original 48 states of the American union (see "About Freehold Mineral Rights”). Because of this, and because the American legal system is ‘friendlier’ than the Canadian system to individuals who sue corporations (see “The Role of Canadian Courts”), thousands of cases involving freehold lease agreements had been heard in the courts of the United States by the 1940's. One of the most significant of these cases was heard by the Oklahoma Supreme Court in 1916 3, and involved a freehold lease agreement in which an oil company had committed to drill a well by a certain date “or” make a delay rental payment in order to continue the lease. The lease also contained a clause allowing the oil company to surrender the lease at any time upon the payment of one dollar. The court found that, since the lease was voidable, at any time, at the option of the oil company, it was also voidable at the option of the freehold owner-lessor. To circumvent this court decision, a form of lease agreement known as the ‘Producer’s 88' was subsequently adopted by most oil companies operating in the United States. In the Producer’s 88, the word “unless” is substituted for the word “or” - if the oil company-lessee does not drill a well by a certain date (usually one year from the date of lease execution) the lease terminates “unless” the oil company makes a delay rental payment. This wording change prevents the freeholder from terminating his or her lease agreement at will, and gives the oil company-lessee the option of either paying delay rentals to continue the lease or allowing the lease to terminate. Over the years, most of the major American oil companies developed their own particular form of Producer’s 88 in response to their own experiences in the courts of the United States.

When American-based major oil companies became active in western Canada following the Leduc discovery, it was natural for these companies to use the ‘unless’ form of freehold lease agreement which they had developed south of the border in their dealings with Canadian freehold owners. Many of the independent Canadian producers that became active in western Canada after Leduc also adopted ‘unless’ form of freehold lease agreements based on the Producer’s 88. In consequence, in the quarter century after the Leduc discovery although many different forms of freehold lease were entered into by Canadian freehold owners, the great majority were ‘unless’ leases.

The ‘unless’ form of freehold lease agreement came before the Canadian courts on a number of occasions in the quarter century following the Leduc discovery. In most instances, the Canadian courts applied the legal principle of contra proferentum (any ambiguity in an agreement is to be construed against the party that drafted the agreement) and strictly interpreted this form of lease against the energy company-lessee. The courts found that ‘unless’ rental payments were made on time and ‘unless’ the company could provide proof of timely payment, an ‘unless’ form of lease automatically terminated on its own terms. As a result, much to the consternation of the oil and gas industry, a number of valuable leases were terminated in situations where the involved companies had purportedly lost receipts or made administrative errors. Predictably, this ‘judicial battering’ resulted in changes to freehold lease agreements as lawyers for various energy companies attempted to provide their companies with greater protection.

In 1973, when the first edition of “The Oil and Gas Lease in Canada”4 was published by the late John B. Ballem, Q.C., there were “as many varieties of lease forms as there were oil companies”4 in western Canada. In his book, the late Mr. Ballem, who was recognized as Canada’s “dean of the energy bar”5, proposed a model form of freehold lease which would: “remove the hazards to the lessee, improve the position of the lessor, and generally provide a framework within which the minerals could be developed in a reasonable and equitable fashion”6. In the 2nd edition of his book, published in 1985, Mr. Ballem acknowledged that further changes to freehold lease forms had occurred which were “designed to improve the lot of the lessee and to enhance the security of his tenure, to the disadvantage of the lessor in some instances”, and re-iterated his call for a “‘standard’ oil and gas lease which would adequately protect the position of the oil company while at the same time treating the mineral owner fairly”7. In response to Mr. Ballem’s suggestion, a joint committee of the Canadian Association of Petroleum Landmen (the “CAPL”) and the Natural Resources Section of the Canadian Bar Association was formed. In 1988, this joint committee released a standard form of freehold lease agreement for use in Canada known as CAPL 88. Three years later, a revised standard freehold lease form known as CAPL 91 was released by the joint committee. The most recent CAPL standard lease form, known as CAPL 99, was released in November of 2000. According to Mr. Ballem, 95% of the freehold leases currently being negotiated in western Canada now follow the CAPL form8.

Since 1988, Canadian freeholders have typically been confronted, not with an oil company landman armed with a printed form which is the product of that particular company’s legal and business experience, but by a land agent, acting on behalf of an unidentified oil company, armed with a printed form which is the product of the collective business experience of the CAPL and the collective legal experience of the Canadian Bar.

The landmen who comprise the CAPL and the lawyers who comprise the Natural Resources Section of the Canadian Bar Association have been eminently successful in achieving Mr. Ballem’s first goal of protecting the position of the oil company-lessee. According to the late Mr. Ballem: “When it comes to termination, the CAPL lease is pretty well bullet proof”.9 In other words, no matter what an oil company-lessee does, it is impossible for a freehold owner-lessor to terminate a CAPL lease agreement, through the courts or otherwise, without the oil company-lessee’s consent. In FHOA’s view, this is not just unfair, it is offensive. And offensive lease forms are just the start of the problems faced by Canadian freehold owners (see “Conflicts Between Lessees & Lessors”, “Role of Regulatory Authorities” and “The Role of Canadian Courts”).